Tuesday, June 13, 2017

8 Thoughts and 4 Questions on the DOL Fiduciary Rule and Its Impacts

As I write this on Tues., 6/13, the fourth day of adherence to the DOL's fiduciary rules (i.e., its "Conflict of Interest Rule" and related prohibited transaction class exemptions) has been completed. And the world of financial services continues to revolve.

Over the past few weeks I've had a number of thoughts about the rule:

1. Who do you represent? It seems to me that most of the problems exist when a person tries to wear two hats. In the end, you either represent the manufacturer of a product well (in an arms-length relationship, typically), or you represent the client well (as a fiduciary). You can't do both - successfully.

Here's a rule designed to keep you out of trouble ... If you represent the client, get paid only by the client. If you represent the product manufacturer, and you distribute products, get paid from the product. Don't mix the two.

2. The impartial conduct standards, with their application of the prudent investor rule, are tough in their application of the investment adviser's duty of due care.

Advisers of all ranks need to step up their due diligence. To me, there have always been two key inquiries: investment strategy; and investment security or product due diligence.

A) Investment Strategy Due Diligence. You have the duty to minimize idiosyncratic risk, under the prudent investor rule. This is more than just minimizing a portfolio's standard deviation. It also involves not suffering a permanent long-term underperformance of the portfolio.

Perhaps one way to address this issue is by asking this question ... "If you deviate from a "total stock market" / "total bond market" / "total universe of publicly traded REITs" portfolio, what solid reasons do you have for doing so?"

There are many solid reasons for deviating from such a portfolio. But which ones are supported by strong evidence? Can you back up your asset class selection, and your means of mixing those asset classes (i.e., through strategic or tactical asset allocation), via proper evidence, or is what you are doing more akin to speculation?

If your investment strategy is challenged, you are likely to possess the burden of proof. (Generally speaking, those who claim the use of a prohibited transaction exemption bear the burdens of demonstrating their allegiance to their conditions.) Accordingly, can you prove that your investment strategy is defensible? Specifically, can you prove your investment strategy makes sense by the support of expert testimony, and is not just based upon speculation? Will your expert's testimony even be admissible?

Note that to have your expert's testimony admitted in a judicial proceeding, Rule 702 of the Federal Rules of Evidence incorporates the Daubert standard, which is also followed by more than half of the state courts:

RULE 702. TESTIMONY BY EXPERT WITNESSES

A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if:

(a) The expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;

(b) The testimony is based on sufficient facts or data;

(c) The testimony is the product of reliable principles and methods; and

(d) The expert has reliably applied the principles and methods to the facts of the case.

(Emphasis added.)

Very generally, your expert's opinion must be based either on strong academic evidence, extensive back-testing, or some other robust and reliable analysis.

Ultimately, the judge is the gatekeeper, ruling upon whether an expert's testimony is reliable (and hence relevant to the matter at hand), and therefore admissible.

B) Is Your Investment Product Due Diligence Up to Par?

Under the prudent investor rule, you possess the duty to not waste the client's assets. In the world of pooled investment vehicles, such as mutual funds, this means paying close attention to fees and costs. A huge amount of academic research supports the conclusion that higher investment product fees and costs lead to lower returns, especially over the long term.

While mutual funds and ETFs provide a means of diversification among individual securities, the fees and costs of such funds deserve intense scrutiny. In essence, as seen in many cases brought against plan sponsors over the past decade, if you have the ability to recommend a lower-fee-and-cost mutual fund or ETF versus a higher-cost mutual fund or ETF, all other things being equal, do so!

It's time to up your game, when you undertake due diligence. Do the factors you apply in selecting investment products (to implement your strategy) flow from either common sense or do they possess academic support? Are you examining all of the fees and costs of the fund at hand? Are you comparing the product to all others in the marketplace?

If you are using alternative investments, then the degree of due diligence required only increases. Intense due diligence is required. Do you possess the expertise to undertake such due diligence? Have you throughly documented your due diligence efforts?

Want to use B.I.C.E. to accept product-related compensation, including 12b-1 fees, payment for shelf space, soft dollar compensation, etc.? You are walking into a minefield.

Smart individual advisers will avoid using B.I.C.E.

The problem is not with the impartial conduct standard's "no more than reasonable compensation" requirement. If you are providing services which are difficult to quantify or compare (such as financial planning which is goals-based, and especially life planning services), you won't need to be concerned much about challenges to your fees. It is very, very difficult to "benchmark" professional counseling fees against other fees. In fact, courts resist interfering in fee disputes, unless the fees are clearly outrageous for the services provided.

But, if part of your fees are derived from the products, those fees come from somewhere. For example, payment for shelf space is derived from higher fund management fees. And 12b-1 fees that provide little or no benefit to fund shareholders. It is very, very difficult to justify higher product costs, especially when they increase your compensation. That's why it is important to levelize compensation (at the firm level), such as by crediting third-party compensation received against advisory fees.

Of course, it is far simpler - and less costly from a systems and technology standpoint - to just adopt an approach where all compensation is received from the client, directly, and product-related compensation is eschewed.

4. American business owners (i.e., plan sponsors) should rejoice.

Plan sponsors run businesses. They are not investment experts. So they turn to retirement plan consultants to assist them in fulfilling the plan sponsor's fiduciary duty. Plan sponsors rely upon the recommendations these consultants make.

But, as so often seen in the class action cases brought against plan sponsors to date, in nearly every instance the "retirement plan consultant" (broker-dealer) is dismissed from the case. Why? Because the consultant, under the DOL's prior definition of fiduciary, was not a fiduciary and did not possess a duty of care. They only possessed something less - the vague duty of suitability.

Now, plan sponsors will be able to hold their consultants responsible. And, as a result, consultants will give (collectively) much better recommendations on which funds to include in 401(k) and other ERISA-covered plan accounts.

The result is a shifting of costs (relating to potential liability for inappropriately choosing products) away from American business owners and onto the retirement plan consultants. As it should be - for when advice is provided by retirement plan consultants, they should be held accountable for that advice.

5. The American economy's future is brighter.

As consumers continue to possess savings from less fees and costs, their retirement account balances will grow larger over time.

These accumulated assets, in turn, provide the fuel for the American economy. As greater savings and larger investment balances take place, over time, greater capital is available. This lower the cost of capital for American business. It will provide the fuel to transform innovation into new products and services that benefit us all.

It is difficult to quantify the amount of increased capital accumulation, here in the United States, as a result of the new DOL rules. In part because the DOL's quantitative analysis focused on IRA accounts, and the often-cited "$17 billion a year in savings for retirement investors" does not include the additional savings likely in 401k and other ERISA-covered qualified retirement plans. Nor do the savings include the spillover likely to result as non-qualified assets are increasingly likely to be managed under a fiduciary standard.

Still, it might be speculated that the pool of capital available to American business owners, as a result of the DOL's fiduciary rule alone - should the rule continue - will be 10% greater in 15-20 years (and perhaps much, much greater). And, the effect is compounding, spurring on U.S. economic growth for generations to come.

6. Changes in law and regulation creates winners and losers; competition is enhanced.

ERISA, and the old DOL regulations, created winners and losers. For example, plan sponsors incurred liability to employees, while brokers (upon whom they relied) usually possessed none. This shifted costs from Wall Street and the insurance companies (the product manufacturers and their distributors) to American business owners (plan sponsors). In essence, the old DOL regulation, adopted in 1975 and much out-dated, prevented (through ERISA's preemption) the application of state common law fiduciary duties on those providing advice to sponsors of ERISA-covered retirement plans.

The changes in the law and regulation create winners and losers as well. There are many in American business that stand to benefit. First and foremost are plan sponsors - business owners that strive to do the right thing for their employees, by providing retirement security for them.

Of course, those who stand to lose under the changed regulations have, and continue to, scream the loudest. As seen in the media, they profess that they embrace acting in their customers' "best interests." But they resist real accountability for the advice they provide.

The fact of the matter is - when investment and insurance products are forced to compete on their merits - and not on the basis of how much revenue-sharing or other payments they provide - true competition among product providers results. And isn't true competition in the marketplace what we desire to promote?

When you create true competition in the marketplace, the strong will survive. As it should be.

Some insurers stand to lose billions and billions of dollars a year from the changes in the proposed regulation. Even more than the DOL predicts, in my view, as a "tipping point" may have been reached in the marketplace. Not only IRA accounts and ERISA-covered retirement plans are affected, but the application of fiduciary principles will increasingly occur to other accounts, as well.

Low-cost investments will win out. (This includes many but not all passively managed investments, and some low-cost actively managed investments.)

But high-cost active management is on its way out the door (at least, substantially). Most high-cost variable annuities, hedge funds, and non-publicly traded REITs cannot be recommended under the prudent investment rule, once you undertake an independent, objective cost-benefit analysis of the product involved.

And recommendations to purchase immediate fixed annuities, or equity index annuities (also called fixed index annuities) - from insurance companies that are not highly rated as to their financial strength - are also problematic. (In Australia, when a similar standard was imposed, financial advisors largely discontinued recommending immediate lifetime annuities from insurers with low financial strength ratings). Fortunately, some good low-cost VAs, and immediate annuities from strong insurers exist. [And I hope that financial advisers will increasingly suggest for their retired clients annuitization of a portion of the retirement nest egg over the client's lifetime, given the robust academic support for this approach.]

The underlying investment concept of EIAs is a good one, from the standpoint that they could form a portion of a client's overall portfolio (generally, as part of a fixed income allocation, although other approaches to how EIAs are incorporated into an investment portfolio are possible). But the control by the insurance company of its own profits, the lack of transparency in the products, their complexity, and their high embedded costs create an opportunity for some company to come along and provide a much better EIA from a highly rated insurer.

Cash value life insurance sold as a retirement planning vehicle? Just say no. (The explanation of the tax trap that awaits, the the fees/costs incurred versus the benefits achieved, could occupy a dozen or more pages.) (However, there are instances, such as for asset protection purposes for clients engaged in high-risk professions, that the limited use of such tools can make sense.)

With so much money at stake, the insurance lobby's fight over the DOL rule's continuation, after 1/1/2018, will be brutal. In particular, the insurance lobby has always been among the most powerful in Washington, D.C. But, hopefully, common sense will prevail. But only if we continue to educate policy makers that the imposition of bona fide fiduciary obligations:

Creates true competition in the marketplace;

Aids American business;

Will spur on U.S. economic growth, especially over the long run; and

Provides increased retirement security to our fellow Americans.

8. We possess an inflection point that accelerates the trend toward fiduciary advice and away from product sales.

The transition from a product seller (paid from products) to a fiduciary adviser (paid by the client) can be a tough one. Especially so when credits must be provided against future advisory fees, due to commissions recently paid. Adviser's compensation may be depressed, at least for a period of time.

Yet, when the transition is made, it is readily apparent that:

- Clients are happier; they have greater trust in their adviser; and

- Advisers are happier; they prefer being on the same side of the table as the client.

Advisers who have transitioned from commission-based compensation (product sales) to fee-based compensation (advisory fees, in a fiduciary relationship) report that they enjoy going to work every day. Free from the need to undertake transactions to make a living, they can focus more on the objectives of the client. They tend to increase their own personal counseling abilities.

One can easily question the "value proposition" of many broker-dealer firms today. Especially from the fiduciary adviser's standpoint. Many RIA firms utilize discount brokerage firms as custodians (such as TD Ameritrade, Schwab, Fidelity, and several others). These discount brokerage firms compete to provide their services, to RIAs. The result is often far less costs incurred by clients.

So many registered representatives have left to form, or to join, fiduciary RIA firms in recent years. Yet, one hardly ever hears of advisers that move from RIA firms to broker-dealer firms (or from a fiduciary relationship with their clients to a non-fiduciary one).

The DOL fiduciary rules, even if only effective for 7 months or so, will accelerate the long-observed trend away from commission-based compensation,and toward fee-based accounts.

Questions Remain. In the months ahead, perhaps we will have answers.

A. How enforceable are the impartial conduct standards today, via private action?Do they, as I have previously written about, constitute implied terms of express contracts? (Even though the DOL does not require during this transition period that the warranties to act in the client's best interests be expressly included in client agreements). If so, then these standards apply to existing IRA accounts that are not grandfathered. And that is a huge event - as the standards would be enforceable by private legal action (judicial actions or, much more commonly, individual arbitration proceedings).

(It is clear that the impartial conduct standards now apply to plans and accounts governed by ERISA, and also now apply during the IRA rollover decision-making process. But I continue to hear varied opinions as to whether the impartial conduct standards can be enforced as to IRA accounts where no IRA rollover takes place, and grandfathering of the account has not taken place.)

B. Is commission-based compensation for mutual fund sales, such as Class A mutual fund share sales, incompatible with Modern Portfolio Theory (which, in turn, is incorporated into aspects of the prudent investor rule)? Given that asset classes need to be rebalanced - whether you are undertaking either strategic or tactical asset allocation - and that previous funds purchased on a commission basis would need to be sold (at least in part) within what, in some market situations, is a relatively short time, how can the payment of commissions not be deemed a waste of client assets?

C. Will registered representatives see their U-4s dinged to a very large degree?One of the many things I don't like about B.I.C.E. is that firms can receive additional product-related compensation, but advisers' compensation arrangements must generally be level. That means that the economic incentives of broker-dealer firms and their advisers are different, and distinct.

And this creates, in turn, a terrible risk for advisers. Should clients file complaints and/or sue (or compel arbitration), firms may see the resulting liability simply as a "cost of doing business." Brokerage firms' reputational risks are generally minimal, as such firms can overcome bad publicity by extensive advertising, by blaming occurrences on "rogue brokers," or even by preventing publicity at all (in settlement agreements). But advisers have their U-4 at risk - and the adviser's reputation is everything.

I am concerned that advisers who practice in firms that use B.I.C.E. to receive additional compensation (paid to the firm) are putting themselves at risk. I suggest advisers insist on not using B.I.C.E. (except its requirements, under BICE Lite, for IRA rollovers). And ... no proprietary products. No principal trades. No products that pay 12b-1 fees or other forms of revenue sharing to the firm. And no substantial limits placed upon the adviser's ability to survey the universe of investment products and to recommend the best ones out there.

Again, keep your compensation received from the client completely separate from products fees and costs. When you mix them, bad results will occur.

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Ron A. Rhoades, JD, CFP® sailed across the Atlantic on a tall ship, performed in theme parks and road shows in Europe and America as a Disney character, rowed on a championship crew team, marched in the Macy’s Thanksgiving Day Parade, marched in competition with a state-champion rifle drill team, undertook a solo one-week trip into the Everglades, escorted numerous celebrities around Central Florida, performed as a “Tin Man” at a mountaintop theme park called “The Land of Oz” in Beech Mountain, NC, and served as a stage manager and talent scheduling coordinator for entertainment productions at Walt Disney World. And then he graduated college.

Since then, Ron Rhoades earned his Juris Doctor degree, with honors, from the University of Florida College of Law, which was preceded by a B.S.B.A. from Florida Southern College. Ron Rhoades has 30 years of experience as an attorney, with nearly all of those years substantially devoted to estate planning, tax planning, and retirement plan distribution planning. Ron also has over 15 years as a personal financial adviser. He was a principal with an investment advisory firm where he served as its Director of Research and Chair of its Investment Committee.

The author of numerous articles published in financial industry publications and several books, Dr. Rhoades has been quoted in numerous consumer and trade publications, and has been interviewed on Bloomberg's "Masters in Business" radio show segment. He writes occasional articles for industry publications. Ron is a frequent speaker at local FPA chapter meetings and national conferences in the financial planning and investment advisory professions.

Ron Rhoades was the recipient of The Tamar Frankel Fiduciary of the Year Award for 2011, from The Committee for the Fiduciary Standard, as he “altered the course of the fiduciary discussion in Washington.” He was also named as one of the Top 25 Most Influential persons associated with the investment advisory profession in 2011 by Investment Advisor magazine, and was voted to the “Sweet 16 Most Influential” in Wealth Management’s 2013 “March Madness” competition. Dr. Rhoades was also named as one of the "Top 30 Most Influential" members in NAPFA's 30-year history in 2013. This blog was also called one of the "Top 25 Most Dangerous" in financial services.

Ron A. Rhoades, JD, CFP® became Program Director for the Financial Planning Program (B.S. Finance, Financial Planning Track) at Western Kentucky University's Gordon Ford School of Business in July 2015. He provides instruction to highly motivated, exceptional undergraduates students in such courses as Applied Investments, Retirement Planning, Estate Planning, and the Personal Financial Planning Capstone course. He has previously taught courses in Insurance & Risk Management, Employee Benefits, Money & Banking, Advanced Investments, and Business Law I and II.

Ron also serves on the Steering Committee of The Committee for the Fiduciary Standard, on whose behalf he frequently travels to Washington, D.C. to meet with policy makers in Congress and in government agencies regarding the application of the fiduciary standard to personalized investment advice. He also serves on NAPFA's South Region Board of Directors.